Saudis and Russia Unite to Handle Pinocchio Problem

(Bloomberg) -- A deal to extend record OPEC+ output cuts was going smoothly -- until Saudi Arabia and Russia discovered just how much some of their allies had been cheating.

In private conversations, Saudi Arabia Energy Minister Prince Abdulaziz bin Salman and his Russian counterpart Alexander Novak had agreed with little fanfare on May 28 to extend oil production cuts by one more month. Their bosses had spoken the day before. With the two power players aligned, Prince Abdulaziz suggested bringing the meeting with other OPEC ministers forward, and Novak had no objection.

The cartel appeared on the brink of a deal.

Then, a day later, the trouble started. The first OPEC output surveys, compiled by news organizations and consultants, showed that Angola, Iraq, Kazakhstan and Nigeria weren’t squeezing supply nearly as much as they had promised. Baghdad was the worst offender.

Cheating is as old as the OPEC system of production quotas, which goes back to the mid-1980s. Academics call it the “free rider” problem: Someone benefits from everyone else’s effort without contributing. In OPEC, ministers call it the “Pinocchio” problem.

Saudi Arabia had long urged other members to share the burden more equitably. Russia, a long-term laggard that has now converted to strict compliance, joined the Saudis in their push. It was as if the brief but vicious price war of earlier this year had never happened.

“All in all, mission accomplished,” said Harry Tchilinguirian, head of commodity market strategy at BNP Paribas SA. “But it would not have happened without Saudi Arabia and Russia coming together and singing from the same song sheet ahead of the meeting.”

Bluff and Drama

Initially, the four laggards resisted. What followed was a week-long drama that pitted Riyadh and Moscow against fellow oil nations, according to officials involved in the talks, consultants and oil traders, who asked not to be named. Everyone had an excuse, from technical problems to errors of measurement. But Moscow and Riyadh took a hard line.

The Russian delegation made clear the one-month extension was “contingent” on better compliance, according to a person familiar with the message. Days later, Novak explained his view during his OPEC+ opening speech: “It is important to note the market is still fragile and needs decisive action. So that’s why it’s now as important as ever to maintain 100% conformity.”

Saudi Arabia went a step further: Not only did it insist that compliance had to improve to 100%, it asked the cheaters to compensate for their past sins. They would have to cut deeper from July to September to make up for their over-production in May and June -- a particularly painful punishment just as oil prices are rising.

Soon, Prince Abdulaziz, a seasoned oil diplomat, rallied other members behind his proposal and he presented an ultimatum: The whole OPEC+ agreement was contingent on the four countries accepting the concept of compensation.

بدء الاجتماع الوزاري التاسع والسبعين بعد المائة لمنظمة الدول المصدرة للنفط (أوبك) من خلال جلسة افتراضية، يتبعها الاجتماع الوزاري الحادي عشر لدول منظمة أوبك والدول المنتجة من خارجها (أوبك+) pic.twitter.com/EQiuRJmrJ3

— وزارة الطاقة (@MoEnergy_Saudi) June 6, 2020

After some diplomatic wrangling, Nigeria, Angola and Kazakhstan bowed to the pressure. But Iraq was resolutely against the deal. Ali Allawi, who was representing Iraq as acting oil minister, sent a letter saying Baghdad would only be able to fulfill its quota by the end of July -- and rejected the idea of compensation.

With the talks at an impasse, Russia and Saudi Arabia told everyone that the early June 4 meeting wouldn’t go ahead, and threatened to cancel the long-planned June 10 gathering too.